Monday, April 18, 2011

So many people have lately been advocating for a return to the Gold Standard. Many have been very vocal about it. So for this post, I will speculate on what would happen should this elusive goal ever come to reality.

Because the Gold Standard entails that money be backed by a fixed price of gold, which has a finite supply, this means that the supply of money will be finite and will grow only as the supply of gold grows (which is hardly at all). So with a return to the Gold Standard, I expect:

1. People will rank their needs and demands in a strict hierarchy. Because of the Standard, people will equate money with gold, and will treat it accordingly. They will hoard and conserve it, and only use it for the most important things, such as for life-saving services.

2. If one part of the economy grows, another part will have to decline correspondingly. There just isn’t enough gold-backed money to go around. If some people become richer, others will correspondingly have to get poorer.

3. Global trade will stop to a standstill. No nation could anymore afford to have a trade deficit, because a deficit entails a loss of gold to the nation that incurs the surplus with them. A loss of gold, and the correspondingly money supply, means a deflation in their entire economy. So every nation will strive even more to be net exporters. No buyers will be left to trade with.

4. Eventually, in this kind of economy, people who still have to make a living will start bartering with one another. Or, and this is my pet speculation, people will eventually develop shadow currency systems. Or call it parallel payment systems. If a gold-backed currency only enables life-savers to get paid for their services, a shadow silver-backed currency will enable people to purchase and pay for education. A parallel copper or aluminum-backed currency will enable people to pay for home builders and tailors. Maybe a shadow currency based on rocks will let people pay for those who cut their hair.

Eventually, maybe even money based on belly lint will let them donate money to blog tip jars, and pay for more episodes of American Idol. Maybe then, only nations that are able to produce a surplus of belly lint can pay for their net imports of American Idol.

In other words, should we ever go back to a Gold Standard, I believe the market itself will form a fiat currency system to allow for more trades and businesses to flourish. Heck, if a shadow banking system can somehow flourish in a system that already has fiat currency, I believe a limited currency system will grow a shadow currency system. (Without a state to back them up though, they can unravel just like the shadow banking system)

What, did you think only those with gold will inherit the earth?

Update: I added this here: I would add that the state's option to be able to spend more, in place of disappearing private spenders during times of escalating private sector desire to save, is an invaluable lifeline during a severe depression, and if we had a gold standard, government spending will only likely crowd out what little private spending is still there.

"If one part of the economy grows, another part will have to decline correspondingly. There just isn’t enough gold-backed money to go around. If some people become richer, others will correspondingly have to get poorer."

Not sure this is 100% true. The value of each grain of gold would become more valuable and gains in productivity would make it even more valuable. This would discourage debt as debt is a killer in deflation. It would probably be the deflation that would be the bigger issue.

I think the problem is that you're tying the nominal price of gold to the real price of gold, or the purchasing power of gold. If production increases, gold's nominal price doesn't have to change. Its real purchasing power would increase. That doesn't mean that certain sectors of the economy would have to be killed off in order to allow growth in others arbitrarily any more than already happens as a result of market activity (i.e., the typewriter industry was killed off to allow for growth in the computer and word processor industry, The equine husbandry industry contracted to allow for growth in the automobile industry, Atari went out of business so that Sega and Nintendo could develop in the game marketplace, etc.).

In addition, it's not impossible for the gold supply to be inflated. Advancements in mining techniques can allow for greater yields of gold mines than before, increasing the supply of available gold.

Also, as far as I understand it, most of the people advocating a return to the gold standard advocate it primarily as their recommendation if their must be a government mandated monopoly on currency. Most of them prefer an open marketplace in currency, where anyone could use whatever they like as a medium of exchange, and banks could print certificates tied to real assets usable as paper money (whether it be gold, silver, palladium, yap, or cigarettes, though those last two are included primarily for historical reference). This would not include the same problems you've included above, but still answer the criticism of fiat currency by allowing for currency that was backed by some tangible asset rather than being provided value through the government's power to tax.

Anon, I see what you mean. What you describe is also what I figured would happen if we took away government fiat, and went back to a metal standard like gold. People will get into more bartering agreements and develop privately-backed shadow currency systems.

My only beef with a multi-currency system is the difficulty of ensuring orderly currency issuance. We'll have an economy with so many currencies being issued by different banks, backed by different assets.

At least, with one monopoly issuer, we can easily control it by making it more accountable to the people who use the currency it issues (make it more transparent than it is right now). If we have many banks issuing their own currencies, it would be more difficult to manage. What happened to securitized loans issued by shadow banks could happen to the currencies privately issued by banks. With no state backing them, they could just as easily lose value during a run, and we could end up with a financial crisis even worse than we had in 2008.

USA has about 8000 odd tons of gold. And its money supply is something like 14 trillion dollars. If you changed the USD to gold backed currency the 8000 odd tons of gold will become the property of China and Japan and all of America's creditors.

With no gold left what justifies getting more gold? More debt? The value of dollar will drop DRASTICALLY and would plunge the country into depression and hyperinflation.

At least that's my understanding. I'm not sure if there are protection schemes to avoid this scenario.

That's why I would just like to see the private corporation that is the Federal Reserve abolished and the ability to print money returned to the US Treasury. One thing worth mentioning is that there currently is a purposeful money shortage and hording through the banking system, which aides those who make a case for austerity. Well done on the thought experiment.

Just to make an addition to this experiment, I believe it would be valuable to mention that the United States produces around 250 tons of gold a year, which may increase with the dependence on the gold standard. That is about 3% of our current holdings of gold here, a year.

It would allow for a slight expansion, but it would definitely limit us from waging indefinite war.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.